Blackout

If California's misbegotten electricity deregulation scheme is ever reduced to canvas or film, the artist would have to be some cross between Hieronymus Bosch and Federico Fellini. At one level, it's a surreal story of grossly compounded economic errors; at another, a gruesome morality tale--not only about corporate greed and political stupidity, but about the illusions of a new economy floating, detached, in some space of its own, unburdened by the problems of old-economy infrastructure and government.

The resulting disaster has caused John Bryson--the CEO of Edison International, in whose offices much of this deal cooked up, to declare it a mistake and call for re-regulation. It is prompting serious talk about having the state seize the whole California power system and construct its own generating facilities. And it has succeeded in making Gray Davis, California's ever cautious New Democratic governor, sound like William Jennings Bryan. "California's deregulation scheme is a colossal and dangerous failure," he said in early January in his state-of-the-state speech. "Never again can we allow out-of-state profiteers to hold California hostage. Never again will we allow out-of-state generators to threaten to turn off our lights at the flip of a switch." Just a month earlier, the same Gray Davis had lit the lights on the state Christmas tree and, in a symbolic show of energy conservation, immediately flipped the switch turning them off.

It's hard to find anyone who denies the part about the colossal failure. Wholesale electricity prices in recent months have averaged 11 times their levels of the previous year. Two of the state's three large investor-owned utilities--the prophetically acronymic IOUs--claim that they've had to absorb those prices, since under the terms of the deregulation law they are not allowed to pass them on to their customers. As a result, they've seen their credit and debt ratings downgraded to junk level on Wall Street and have warned of imminent bankruptcy. That's meant not only layoffs and warnings of reduced service but, as the utilities' debts mounted to a reported (but unsubstantiated) $12 billion, problems in securing enough credit to buy the power they needed. This winter, a season when California usually exports surplus power to the Pacific Northwest, the California Independent System Operator (Cal-ISO), which has been managing the grid since deregulation went into effect three years ago, has declared one power emergency after another. In January the rolling blackouts began. That the lights stayed on as long as they did was largely the result of federal emergency orders (issued by then-Energy Secretary Bill Richardson and temporarily extended by the new Bush administration) requiring private generators in the West to provide California the electricity it needed.

But unless the Federal Energy Regulatory Commission (FERC), comes to the rescue with a long-term cap on wholesale prices--something it has steadfastly refused to do--the "never again" cross-of-gold part of Davis's speech will be mostly bluster. The measure of this disaster is that there are no quick fixes--or fixes of any kind--that aren't likely to cost Californians a bundle of money and, very likely, to deal California's economy a significant blow. Deregulation in California is dead; but re-regulation by the state, as even the consumer advocates now acknowledge, is nearly impossible.

Almost everything that could have gone wrong did go wrong. And everywhere, there are Bosch's little devils--corporate officers, politicians, regulators, economic theorists who believe that electricity is just another commodity like corn or cotton. As early as last summer, when San Diegans found that their electric bills had suddenly tripled, Paul Maslin, Davis's pollster, warned that this could be the "political equivalent of The Perfect Storm." San Diego retail prices, which had become the first to be unfrozen under the restructuring law, were quickly re-capped by a panicked legislature with an implicit promise to San Diego Gas and Electric that someone--the taxpayers, the ratepayers--would make up the difference between the capped retail price and the skyrocketing wholesale prices the utility was paying. To this day, no one knows who that someone will be.

The list of errors is almost endless. Enamored of the larger mystique of open markets and deregulation, and driven by large industrial energy consumers looking for cheaper prices, the California legislature rushed through AB1890, the deregulation bill, in a few short weeks during the summer of 1996, even though most members had no idea what the bill contained. In fact, there was almost no dissent from anyone: Environmentalists and consumer advocates had themselves been frustrated by what they regarded as bloated costs and the nuclear fiascos that ratepayers had been stuck with under the old system.

The process under which AB1890 passed was known even then as "the Steve Peace death march" (for the bill's chief legislative advocate). At bottom it rested on wild and unfounded expectations. If the state's three private utilities--Pacific Gas and Electric, Southern California Edison, and San Diego Gas and Electric--were required to sell off their fossil-fuel power plants to independent generators (in many cases, out of-state corporations like Duke Energy or Dynegy or Reliant) and become primarily distribution systems, and if generation of electricity were deregulated and consumers allowed to shop for the cheapest source of power, new providers would automatically come in. The resulting competition would drive wholesale prices down.

What AB1890 ultimately did was almost precisely the opposite, trapping utilities between escalating wholesale prices and retail prices that had been frozen by law. The freeze was designed to protect consumers from price increases until the utilities' "stranded costs" were paid off through monthly surcharges on consumers' electric bills. (These stranded costs were essentially the unrecoverable debt on costly utility company assets, particularly nuclear plants that were expected to be uneconomical under deregulation.) With the one brief exception in San Diego, when the freeze was lifted and electric bills went through the roof, the utilities had no way to pass escalating wholesale costs on to consumers.

Electric Nimbyism

But the list of mistakes goes on:

There was the quaint notion that the extremely low mid-1990s price of natural gas--the fuel that powers roughly 40 percent of California's electricity generators--would stay unnaturally low forever. Instead, natural-gas prices have quadrupled in the past year (in large part because those very low prices discouraged new gas development). The gas-price increases don't come close to explaining the run-up in wholesale electricity rates, which, in the words of Jan Schori, general manager of the Sacramento Municipal Utility District (SMUD), "bear no relation to the cost of generation." But the optimism lasted long enough to prompt the state's environmentally conscious regulators to press for the decommissioning of coal- and oil-fired alternatives wherever possible, thus making the state still more dependent on gas.

There was the gross underestimate, when deregulation was first discussed during the recession of the mid-1990s, of the power that a booming California economy would require five years later. In 1994, says Schori, state officials estimated that California had a 30 percent reserve margin in electrical supply and would have an ample supply until 2003 or 2004.

There was the ill-conceived rule handed down by the California Public Utilities Commission (CPUC)--and abandoned only recently--that barred the utilities from signing long-term contracts for power, thereby making them hyper-dependent on the volatile spot market.

There was the awkwardly structured power exchange and centralized marketing scheme created by AB1890. Supposedly intended to reduce collusion in bidding yet dominated by industry representatives, the complex arrangement made the whole system so opaque that there was no way for regulators or the public to know even after the fact whether there might have been collusion. As a result, says Commissioner Michal Moore of the California Energy Commission, "there is no viable price transparency."

There was plain bad luck with the weather, and there were the uncertainties of the new market. Combined with California's nimbyism and its redundant environmental regulations, these factors discouraged new investment and made the siting and construction of new generating plants particularly slow and difficult. (This past December, even as there were warnings of blackouts, Cisco Systems, one of the Silicon Valley giants that's been driving up demand, was fighting vehemently--with the unanimous support of the San Jose City Council--to block the construction of a new power plant near the huge business complex the company is developing for itself.) AB1890 in no way conditioned the deregulation process on the development of new generating capacity, as some other states did, and virtually none came on line during the 1990s. Some plants have been approved and are now under construction, but most will not be ready for another two or three years. At the same time, the retail price structure had few formal inducements to curb demand.

Unlike virtually all other commodities, electricity cannot be stored in any significant amounts; supply and demand have to be finely balanced by the transmission system. For 20 hours of the day, there may be ample capacity. But if demand spikes in the late afternoon or early evening, especially on days of extreme temperatures, the price paid for sufficient power to get through those four peak hours without blackouts can be astronomical. And everything sold on the spot market for any given period goes at the "market clearing price," which is the highest price paid for that period. In December wholesale power that in the previous year had cost an average of $30 per megawatt hour averaged $330 and was sometimes going for $1,200.

To this day, no one knows for certain whether there was illegal collusion among the generators or the electricity brokers--who have now become major players in the field--to withhold power from the market in order to drive up prices. Nor does anyone know whether the electricity generators who are also in the natural-gas business were exploiting the spiking gas market and making fat profits by selling gas while strategically staying off line until the price of electricity was driven up still further.

What's certain is that on some days this winter, a season when there had never before been electricity shortages in California, as much as 25 percent of the state's generating capacity was off line--some because of scheduled maintenance, but an unusually large part as the result of "unscheduled events." The shortage was partly caused by the now famous inadequacy of the transmission lines between southern and northern California, which is now also the focus of some suspicion. In part it was the result of sellers' refusal to extend credit to the near-bankrupt utilities. But when Steve Larson, executive director of the California Energy Commission, told me that had it not been for those unscheduled events, the state would have had plenty of power, the strong between-the-lines inference was that the generators were manipulating the market.

On one December day, the CPUC conspicuously launched surprise inspections of off-line plants; a month later, in his state-of-the-state remarks, Davis called for additional inspectors and for new laws making it a felony to "deliberately withhold power from the grid, if it results in imminent threat to public health and safety." Given the fact that it's virtually impossible to second-guess management decisions about plant maintenance, most of that was ineffectual posturing--especially on a day in January when Davis himself was about to join negotiations in Washington, D.C., aimed at stabilizing the state's power supply and convincing the generators to accept moderate-priced long-term contracts.

But the suspicions are widespread. Even the FERC, which was locked into its free market ideology long before George W. Bush became president, has acknowledged that recent wholesale prices in California didn't meet the "just and reasonable" standard mandated under federal law, though the agency has taken no substantive action to enforce it.

Pennsylvania, the Un-California

For Americans as a whole, the great lingering question raised by the California story devolves to a simple matter of whether versus how: Is it just that California messed it up so badly, as the free market true believers contend? Would it have worked had it been done wisely? Or is deregulation in electricity service an inherently bad and unworkable idea? What if the state had not discouraged--indeed, prohibited--the privately owned utilities from entering into long-term hedge contracts? What if the utilities had not been pressured to sell all their fossil-fuel generating capacity? What if the state had moved more gradually, to make certain that there was adequate supply before moving on? What if it had made greater efforts from the very beginning to encourage conservation, as some of California's publicly owned utilities have been doing? What if the state had insisted on real-time metering (as urged by experts such as Severin Borenstein, director of the University of California Energy Institute), which would have enabled utilities to charge at least their large users something approaching the real cost of the peak-hour energy they were using, thereby reducing demand for the costliest chunks of power? In a market-based system, shouldn't consumers, especially large industrial users, pay the real cost of reliable power?

Pennsylvania, which started down the deregulation road shortly after California did, is often cited by defenders of deregulation as a model--the un-California, as it were, where they did things right. Pennsylvania capped retail prices by law during a transition period intended to last, in some cases, until 2010. The utilities that could buy power for less would make a profit; those that did not would have to eat the loss, and unlike California, they could not defer the costs. But the Pennsylvania utilities were not required to sell any of their generating plants, and those that did were required to enter into long-term contracts with the buyers at moderate (and stable) prices to buy power from the plants they had just sold off. In an effort to encourage competition, the state also set up an accessible system that allows consumers to choose alternate suppliers--and in some regions, as many as 15 percent of users, most of them residential consumers, have done so. Sonny Popowsky, the official consumer advocate of Pennsylvania, has asked Congress to grant the FERC greater authority to control wholesale prices. But on the whole, he says, the state's partial deregulation--he calls it a restructuring--is working.

A year ago, however, everything seemed to be working in California as well. The message that California is now sending has caution written all over it. About half the states have started down the road to deregulation. But as the rising cost of natural gas drives up prices, and as the bad news comes in from the Golden State, states that had been marching down that road--New Mexico, Nevada, Arkansas, Mississippi, Oregon, Montana--are all having sober second thoughts. Colorado, which, in the view of outside experts, did the only careful analysis before it leaped, last year backed away from restructuring. In Vermont, Governor Howard Dean has said he was glad the legislature resisted him two years ago when he called for deregulation.

Such second thoughts are powerfully reinforced by the slow emergence of fundamental economic arguments pointing out how different electricity is from all other commodities--or from phone service or the airline industry. In an important analysis, Richard Rosen--executive vice president and director of the Energy Group at the Tellus Institute, a Boston consulting firm--and two of his colleagues conclude that "even under the best of circumstances, the deregulation of the electric industry cannot be trusted to deliver on its many promises."

They note that some marginal increases in efficiency would occur in an ideal market--the unlikely situation in which "participants would ignore their own self-interest and refuse to engage in strategic bidding and other means of exercising market power." But even those benefits would not compensate for the difference between the high marginal cost of new supply, which is what market rates are based on, and the generally lower average embedded cost of existing supplies, which is the basis for regulated rates. "That means, by definition, that most states cannot expect market prices to be lower than regulated rates would have been in the near future unless deregulated markets can generate large efficiency improvements that regulated rates cannot." In an unregulated market like California's, moreover, there is no mechanism to guarantee adequacy and reliability of supply. In theory when supply threatens to run low, new generators will enter the field; but because of market uncertainties, restrictions to access, and other constraints, that's hardly assured.

Combine that with rising natural-gas and oil prices, which raise the price of all energy, and with the possibility (in Rosen's worst-case scenario) of players "who see much greater gain in gaming the market than in going after the elusive and difficult goal of streamlining their business for competitive advantage," and the country "could lose the huge benefits that we previously had from low embedded cost types of generation such as hydro and coal." In addition, a deregulated system would offer few incentives to encourage research and development of more environmentally friendly or socially desirable energy sources.

Rosen and his colleagues also raise the multibillion-dollar issue of stranded costs. When California's restructuring bill was passed in 1996, it allowed the three utilities to recover from ratepayers some $17 billion the companies still owed on their nuclear and other supposedly "uneconomic" plants. But given the huge run-ups in rates, those plants are now worth far more than was assumed five years ago. Rosen warns that "unless stranded costs are adjusted strongly downwards in the near future, ratepayers may lose more money by overpaying for these stranded costs" than they would have paid for them under regulation. In California the ratepayers are shelling out billions for stranded costs even as they're about to shell out more and more for the electricity that those "uneconomic" plants are producing. But here too, as Rosen says, "the basic story is yet to be told."

An ongoing audit by the CPUC has been trying to determine how much of the utilities' professed $12-billion debt for wholesale power is real and to what extent it's merely an accounting trick in which income--particularly from the sale of power from plants the companies and their subsidiaries own outside California--goes into one corporate pocket even as the other pocket is turned inside out. The Ralph Nader advocacy group Public Citizen recently charged, for example, that while "two utilities claim to have racked up such significant losses that they are threatening to file for bankruptcy, their parent companies have embarked upon a billion-dollar spending spree, spending more than $22 billion on power plants, stock buybacks and other purchases that far exceed their alleged $12 billion debt from California operations." The question was sharpened in mid-January with the disclosure that PG&E Corporation, the parent of Pacific Gas and Electric, had won FERC permission to restructure itself to shield the corporation's profits and stockholders from the subsidiary's debt. (The news had no impact on Wall Street, however, where the company's shares continued their downward slide.)

But maybe the most telling argument about deregulation is also the simplest. As the California meltdown took its toll, publicly owned utilities like the Los Angeles Department of Water and Power (LADWP) and the SMUD, the Sacramento Municipal Utility District, were doing fine. The only effect on them was when they were forced under state law to share their electricity output to mitigate the blackouts caused by the mess in the rest of the system. Neither public utility was covered by the deregulation law; neither was forced to divest itself of generating facilities (and neither did), and, to the extent that they needed outside power, both protected themselves with long-term contracts. Both have also made extensive efforts to reduce demand through conservation. Neither has raised its rates. Indeed, at the LADWP, General Manager David Freeman has been selling surplus power into the grid and making bundles of money to apply toward retiring his utility's debt.

The Ratepayer Revolt

This story is obviously incomplete; it is not likely to be resolved for months and maybe years. In mid-January, as California's utilities faced bankruptcy and the state's power grid manager warned about--and then ordered--rolling blackouts, government officials grew ever more frantic in their search for possible solutions: legislation to give the state the authority to buy power under long-term contracts and sell it at cost to utilities that no longer have the credit to buy it from the generators and traders themselves; negotiations to find the probably unattainable price that the generators will accept and that will not prompt political disaster for the politicians involved; CPUC approval of a modest, 9-to-15-percent consumer rate increase for Southern California Edison and Pacific Gas and Electric; measures such as tax rebates for the buyers of energy-efficient appliances in order to reduce demand; a bill to stop the utilities from selling off the nuclear and hydro generating facilities that they still own; proposals to reorganize the boards of the power exchange and the grid manager to give control to representatives of the public rather than the industry.

In light of President George W. Bush's declaration that California could expect little in the way of federal intervention to get itself out of a mess that, in his view, was of the state's own making, none of those remedies alone is likely to be sufficient without the substantial rate increase that California politicians were doing contortions to avoid. That left only two serious possibilities: a takeover of the utilities by a bankruptcy judge (who would inevitably protect shareholders before ratepayers) or a radical voter-initiative calling for a state takeover of the entire power infrastructure--generating plants, transmission systems, the works--that would make even Proposition 13, California's tax revolt, seem mild in comparison. The initiative's sponsor, Harvey Rosenfield--the tempestuous consumer activist and former Naderite who managed Proposition 103, the successful initiative campaign in 1988 that cut California's exorbitant auto insurance rates--thinks this brewing revolt is like the one against auto insurance rates. But if the electric bills keep rising and the lights keep flickering, the populist potential is far greater. This is more like railroad freight rates in the 1890s than auto insurance rates in the 1980s.

What's certain is that a lot of New California illusions are gone: about the marvels of deregulation, about the new economy, about Gray Davis's future as a presidential contender. This is a Bosch morality canvas: A panicking lot of politicians, Davis chief among them, are sinking ever deeper into a pit beyond their control. And so, very possibly, is the great California boom. In January, Intel, one of the shiniest Silicon Valley icons, announced that it would build no new facilities in California nor expand any existing ones--a reminder that economic tides can still shift precipitously, even in the Golden State. It's also a reminder that even in the highest high-tech economy--where so many believed so fervently in permanent immunity to the doings of government and the mundane matters of infrastructure--things can go to hell fast.

About the Author

Peter Schrag, a longtime education writer and editor, is the author of Paradise Lost: California's Experience, America's Future and most recently, California: America's High-Stakes Experiment. He is a former editorial page editor of the Sacramento Bee.